Small Lenders Wary as Mortgage-Lending Rules Take Effect

Small lenders, already struggling with weak economic conditions and rising interest rates, say new mortgage-lending rules could further crimp their ability to make loans.

The rules, which went into effect Friday, are designed to correct a key deficiency of the home-loan market during the housing bubble: Lenders did not pay enough attention to whether borrowers were able to afford their mortgages. Under the rules, mortgage lenders will be legally responsible for ensuring that consumers can pay back their loans.

Most economists believe the mortgage industry should adapt to the changes relatively unscathed. “While it is a significant adjustment, and there could be some disruptions early on, I don’t expect it will disrupt lending too significantly for too long,” said Mark Zandi, chief economist at Moody’s Analytics.

Nevertheless, smaller lenders say they are going to be cautious about lending because they are worried about the legal risk of making loans that don’t meet new standards defined by the Consumer Financial Protection Bureau. They warn that loans deemed to be outside the CFPB’s standards could be subject to lawsuits from disgruntled borrowers.

“We’re going to be very conservative just to make sure that we’re in compliance and don’t get into trouble,” said Mark Walker, chief executive of Michigan Mutual Inc., a 300-employee lender based in Port Huron, Mich. “There are going to be loans that we did in 2013 that we are not going to be able to do in 2014.”

The CFPB has defined a “qualified mortgage” that satisfies the ability-to-repay mandate as a loan in which borrowers spend no more than 43% of their income on debt, and pay no more than 3% of the loan in fees and other charges.

Mr. Walker said the risk of falling outside these rules is serious. Even a minor error, he said, could cause a lender to fall outside the rules and be unable to sell the loan to an investor such as Fannie Mae or Freddie Mac. As a result, lenders are likely to stay well within the rules—especially nonbank lenders that don’t have their own investment portfolios to hold loans on their books.

CFPB officials say they will monitor the rule’s impact on the housing market and will entertain tweaks if there is a clear impact on the availability of loans. “I think we got the rule right, said Peter Carroll, the regulator’s assistant director for mortgage markets. Nevertheless, he said, “We don’t want to see credit get unduly cut for people, where there are responsible loans being made.”

Several large lenders—including Wells Fargo & Co., Bank of America Corp., Everbank Inc. and Navy Federal Credit Union say they will make loans outside the CFPB’s standards and hold them on their books. They say they are comfortable with the legal risk of such lending.

But some experts say the outcome is still far from certain. “The great uncertainty is what happens to middle-class borrowers,” with decent credit who fall outside the regulator’s guidelines, said Jim Parrott, a former White House housing official now at the Urban Institute. “No one really knows yet.”

CFPB officials made numerous adjustments to ease the rule’s impact on lending. For instance, loans made to borrowers with debt levels above 43% can still be qualified mortgages if they can be sold to Fannie Mae or Freddie Mac, or guaranteed by the Federal Housing Administration. The agency also allowed community lenders to make loans to borrowers with higher debt levels as long as they make fewer than 500 loans per year.

Community lenders say the mortgage rules still don’t give them enough flexibility, noting that small banks experienced low default rates during the housing bust. “I’m not the problem they’re trying to fix, but they fixed me anyhow,” said Jack Hartings, chief executive of the Peoples Bank Co. in Coldwater, Ohio.

Midsize and smaller lenders have been gaining market share of late, as larger lenders have scaled back some parts of their business such as buying loans from mortgage brokers. The market share of the largest 25 lenders has fallen from 90% in 2007 and 2008 to 65% in the third quarter of last year, according to Inside Mortgage Finance, a trade publication.

Meanwhile, mortgage demand has been falling in recent weeks, with rates on 30-year mortgages rising to an average of more than 4.5% last week, up from 3.34% a year earlier, according to mortgage finance company Freddie Mac.

Linda Sweet, president and chief executive officer of Big Valley Federal Credit Union in Sacramento, Calif., said her credit union will largely stop making mortgage loans altogether in 2014 because it has not been able to update its forms and procedures in time.

“The burden of trying to comply with the regulation is just overwhelmingly costly for a small financial institution,” said Ms. Sweet, whose credit union made around 30 home loans in 2013.